PAPER 2.1
QUESTIONS AND SOLUTIONS
SEPTEMBER 2014 DIET
Page 1 of 13
Question 2 - Financial Accounting and Financial Statement Analysis
A firm has a ROE of 20%. The industry average ROE is 12%. Is this a good or poor sign about
the management of the firm?
(3 marks)
Solution 2
It depends on the reason for the 8% gap between the firm’s ROE and the industry.
From DU Pont analysis we know the sources of ROE increase:
ROE = Profit
Sales
X
Profit
Margin (1)
Sales
Assets
X
Assets
Turnover (2)
Assets
Equity
Leverage
Factors (3)
(1 mark)
If the difference is due to improvement in profit margin and/or Asset turnover of the company,
then it is a sign of good management.
(1 mark)
However, if it is due to increase in leverage, then it may not be a good sign as the company’s
financial risk would have increased. Which means the firm is taking on higher (and possibly
unacceptable) risk to increase ROE.
(1 mark)
(Maximum of 3 marks)
Page 2 of 13
Question 3 - Economics and Financial Markets
The Statistician General of the Federation, at the last Investiture of the CIS President made
available to the audience the following information about the Nigerian economy:
GDP
=
N34.52 trillion
Consumer expenditure
=
N23.43 trillion
Government purchases =
N8.65 trillion
Gross investment
N3.79 trillion
=
From the information provided, what is the net exports of the nation?
(3 marks)
SOLUTION 3
GDP = C + G + I + (X – M)
(1 mark)
34.52 = 23.43 + 8.65 + 3.79 + (X – M)
Net exports = (X – M)
(1 mark)
= 34.52 – (23.43 + 8.65 + 3.79)
= 34.52 – 35.87
= -1.35 trillion
(1 mark)
Note: this means imports exceeded exports
Page 3 of 13
Question 4 - Quantitative Analysis and Statistics
Mr. Adejumo, ACS, a portfolio manager allocates 60% of his company portfolio to Nigerian
Stocks and 40% to Nigerian Bonds. The company's research assistance provided the table
below showing total returns for these asset classes for 2009 to 2013:
Year
Equities
Bonds
2009
-1.6%
9.1%
2010
31.7%
-1.1%
2011
7.4%
10.3%
2012
-12.6%
8.0%
2013
-12.4%
8.7%
Question 4(a)
What are the mean returns for the two asset classes?
(2 marks)
Solution 4(a)
(i) Mean return (Equities) = (-1.6% + 31.7% + 7.4% - 12.6% - 12.4%)/5
= 2.5%
(1 mark)
(ii) Mean return (Bonds)
= (9.1% -1.1% + 10.3% + 8.0% + 8.7%)/5
= 7.0%
(1 mark)
Question 4(b)
What is the weighted average return of the portfolio for 2009?
(1 mark)
Solution 4(b)
60% (- 1.6%)
= - 0.96%
+
40% (9.1%)
+ 3.64% = 2.68%
(1 mark)
Question 4(c)
What is the geometric return on the portfolio for 2013?
(1 mark)
Solution 4(c)
Geometric return
=
=
=
=
=
n (1 + r1) x (1 + r2) x ...... (1 + rn)
(1 + 0.0268)
1.0268 - 1
0.0268
2.68%
1
/1
- 1
-1
(1 mark)
Page 4 of 13
Question 5 - Financial Accounting and Financial Statement Analysis
Question 5(a)
The following information is provided relating to the affairs of two companies engaged in
similar trading activities:
Apple Ltd
Berry Ltd
N
N
Ordinary share capital
800,000
500,000
15% debenture
200,000
500,000
Each company earned a trading profit before finance charges of N110,000 in year 1 and
N190,000 in year 2.
The corporate tax is charged at 50% on the trading profit after finance charges have
been deducted. The company pays out as dividends its entire after-tax profits.
Question 5(a1)
Summarize the profit and loss accounts, dealing with the results of each of the two
companies' activities during year 1 and year 2, so far as the information given above
permits.
(5 marks)
Solution 5(a1):
(a) Summary profit and loss accounts:
Apple Ltd
Trading profit
Berry Ltd
Year 1
Year 2
Year 1
Year 2
N'000
N'000
N'000
N'000
110
190
110
190
Less: Finance charges (0.15 x 200,000)
30
30
75
75
Profit before tax
80
160
35
115
Taxation (50%)
40
80
17.5
57.5
Dividend
40
80
17.5
57.5
Page 5 of 13
Question 5(a2)
What is the after-tax profit, expressed as percentage of ordinary share capital for each
company in respect of both year 1 and year 2.
(4 marks)
Solution 5(a2):
After-tax profit as a percentage of ordinary share capital:
Year 1
Year 2
Apple Ltd
40 x 100 = 5%
800
Berry Ltd
17.5 x 100 = 3.5%
500
80 x 100 = 10%
800
17.5
500
x 100 = 11.5%
Question 5(a3)
Discuss the returns earned for shareholders over the two-year period.
(6 marks)
Solution 5(a3):
Each of these companies has earned the same return on total funds employed in year 1
and has enjoyed the same increase in return on total funds in year 2. However, in year 1
Apple Ltd earned a rate of return on equity of 5% while Berry Ltd only achieved a rate of
3.5%. In Year 2 the relative position is a change with Apple Ltd achieving a return of
10% and Berry Ltd achieving a return on equity of 11.5%.
The reason for this is the effect of ‘gearing’. Apple Ltd derives only 20% of its total
resources from borrowing, whereas Berry Ltd derives 50% of its resources from
borrowing. The higher a company’s borrowings, the higher it is said to be ‘geared’.
Because lender have an entitlement to interest of a fixed amount, irrespective of the
level of profits, then in the event of any fluctuation in trading profit the proprietors of the
business, who are entitle to the residue of profit after interest has been paid, will find
that residue of profit fluctuate by a greater proportion than the fluctuation in trading
profit. This effect can be measure by a ratio know as the degree of capital gearing,
computed as:
Profit before interest
Profit after interest
The proportion by which the trading profit fluctuates, multiplied by the degree of capital
gearing, gives us the proporti on by which profit attributable to the proprietors will
fluctuate. In year 1 the degree of capital gearing for each company is:
Apple Ltd
100 = 1.375
80
Berry Ltd
110 = 3.14
35
Thus Berry Ltd is subject to more violent fluctuations in the return on equity than Apple
Ltd because of higher gearing.
Page 6 of 13
Question 5(b)
The draft financial statements of Reliance Limited for the year to 31 March 2012 report a
profit of N385,793. The following issues have not yet been taken into account:
I.
On 10 April 2012, the directors were informed that an insurance claim for a
robbery which had taken place on 22 March 2012 and for which they had
expected to receive N75,800 would be restricted to N21,500.
II.
On 2 April 2012, an accident in the warehouse destroyed inventory valued at
N17,200.
Question 5(b1)
What is the revised profit when these issues are taken into account?
(2 marks)
Solution 5(b1)
N
Original profit
1. Adjusted Insurance claim (75,000 – 21,500)
2. Non adjusting (inventory destroyed)
Revised profit
385, 793
(54,300)
(1 mark)
Nil
(1 mark)
331,493
Question 5(b2)
Briefly justify the treatment of each of the items.
(3 marks)
Solution 5(b2)
i. The reduction in insurance claim is an adjusting event as it occurred before the reporting date
of 31 March 2012. With additional information the financial statement should be adjusted
accordingly.
(11/2 marks)
ii. The destruction of inventory in the warehouse is a non-adjusting event. It should only be
reflected in notes to the account.
(11/2 marks)
Page 7 of 13
Question 6 - Economics and Financial Markets
Question 6(a)
Explain the concepts: currency appreciation and currency depreciation.
(5 marks)
SOLUTION 6(a)
(a) Currency Appreciation and Depreciation
i. Currency appreciation refers to an increase in the value of a currency against other
currencies under a flexible exchange rate system.
An appreciation of a currency’s value makes imports (in the local currency) more
expensive, thereby encouraging additional imports and curbing exports.
(21/2 marks)
ii. Currency depreciation is a fall in the value of a currency against other currencies
under a flexible exchange- rate system.
A depreciation of a currency’s value makes imports (in the local currency) more expensive
and exports (in the local currency) cheaper, thereby reducing imports and increasing
exports.
(21/2 marks)
Question 6(b)
Briefly justify the use of a flexible exchange rate system by some Central Banks.
(3 marks)
Solution 6(b)
A flexible exchange rate system provides a mechanism for coordinating exchange
rates between countries’ currencies that involves the value of each country’s
currency in terms of other currencies being determined by the forces of the demand
for, and supply of, currencies in the foreign exchange market. Its use is justified on
the presumption that with the exchange rate movement equilibrium is attained in
the foreign exchange market of a country.
Hence, under the system, balance of payments, disequilibria (balance of payment
deficits and surpluses) are redressed automatically with minimal intervention by the
Central Bank. It is therefore administratively cheap a system of managing the
country’s exchange rate movement.
(3 marks)
Page 8 of 13
Question 6(c)
In the context of a flexible exchange rate system, analyze the exchange rate movement
(stating whether it is a case of naira appreciation or depreciation) if there was:
Question 6(c1)
Decreased preference for Nigeria’s crude oil outside the country.
(3 marks)
Solution 6(c1)
Analysis of Exchange Rate Movement
The implication of a decreased preference of Nigeria’s Crude Oil is to alter the supply of
foreign exchange and change in exchange rate.
Specifically, this amounts to a reduction in foreign exchange (dollar) availability compared
to naira. Consequently naira depreciates in value.
(3 marks)
Question 6(c2)
Rapid expansion of the Nigerian economy relative to other countries.
(3 marks)
Solution 6(c2)
A rapid expansion of the Nigerian economy is tantamount to increased national
income.
As income rises in Nigeria, there will be increased demand for domestically produced
goods as well as foreign goods.
With substantial increase in imports, more Naira will go into the purchase of
imported goods and that means increased demand for foreign exchange. Hence,
Nigeria’s Naira depreciates against such currencies such as U.S. dollar and British
pound.
(3 marks)
Page 9 of 13
Question 6(c3)
A decision by the Central Bank of Nigeria (CBN) to drive up interest rates in the country
while the Bank of England took no such action.
(4 marks)
Solution 6(c3)
The decision by the Central Bank of Nigeria (CBN) to drive up interest rates in
Nigeria while interest rates in Britain stay constant will likely affect foreign exchange
availability.
British citizens will find Nigeria an attractive place in which to make financial
investments.
To undertake these investments, they will have to supply pounds in the foreign
exchange market to obtain naira.
The increase in the supply of pounds will result in depreciation of the pound and
appreciation of the Naira.
(4marks)
Page 10 of 13
Question 7 - Quantitative Analysis and Statistics
Question 7(a)
Following the deviation of Paddy Limited from its corporate objective of maximizing its
profit, you are engaged to put the company back on its track. Total Revenue and Total
Cost functions of the company were provided by the production manager to assist with
the task:
Revenue (NR) = 920q – 8q2
Cost (NC) = q2 + 20q + 60
Where q is the number of units produced and sold.
Required:
Based on Paddy Limited's desire to maximize profit, use the concepts of marginal
revenue and marginal cost to determine:
Question 7(a1)
The quantity to be sold.
(3 marks)
SOLUTION 7(a1)
At maximum profit level MR = MC
(1 mark)
MR = 920 – 16q (differentiating the revenue function)
MC = 2q + 20 (differentiating the cost function)
(1 mark)
MR = MC = 920 – 16q = 2q + 20
2q + 16q = 920 – 20
18q = 900
q = 900/18 = 50
(1 mark)
Page 11 of 13
Question 7(a2)
The selling price.
(2 marks)
SOLUTION 7(a2)
Selling Price = Total revenue/quantity sold
Total revenue = 920q – 8q2
920 (50) – 8 (50)2
Selling price
46,000 – 20,000 = N26,000
(1 mark)
N26,000/50 =
(1 mark)
N520
Question 7(a3)
The maximum profit.
(2 marks)
SOLUTION 7(a3)
Profit = Revenue – Cost
= 920q – 8q2 – q2 – 20q – 60
-9q2 + 900q – 60
Substitute for q = 50
-9(50)2 + 900 (50) – 60
- 22,500 + 45,00 – 60
= N22,440
Question 7(b)
The Finance Director has approached you to assist in analyzing an investment opportunity
with the following cash flows:
Year
Cash flows (N’000)
0
1
2
3
4
-9,500
3,000
4,700
x
3,200
Given that at a cost of capital of 20%, NPV is N585,000, estimate the cash flow for
year 3 (that is, find x).
(5 marks)
Page 12 of 13
SOLUTION 7(b)
Year
Cash
flow
(N’000)
- 9,500
Discount
factor @
20%
1
Present
Value
(N’000)
(9,500.00)
1
3,000
0.833
2,499.00
2
4,700
0.694
3,262.00
3
X
0.579
0.579X
4
3,200
0.482
1,542
Net Present Value (NPV)
585
0
= -9500 + 2499 + 3262 + 0.579X + 1542 = 585
(Layout 2 marks)
(1 mark)
(2 marks)
0.579X = 585 + 9500 – 2499 – 3262 – 1542
0.579X = 2782
X = 2782/0.579 = N4,805 (‘000)
Page 13 of 13